A Monetary Policy Rule for Developing Countries

Abstract

The purpose of the study is to develop a prudent behavior index in order to shed light on the significance of central bank independence (CBI) as a monetary policy rule for developing countries. Many published studies have found that while CBI is beneficial for highly industrialized nations, it does not appear to help developing countries. This raises the following possibilities: there may be flaws in the many studies that have been done on the subjects, or there may be some characteristics of developing countries that cause them to respond differently to CBI. Exhaustive literature review of this study has concluded that the measures of CBI previously used, mainly legal or proxy measures, are flawed. The prudent behavior index which serve as a proxy for the behavioral measures of CBI have been developed in this research. The conclusion drawn from the empirical findings is that, with respect to inflation, a prudent behavior index is both explanatory and prescriptive has been identified, tested, and found to be predictive. That is, a developing country that follows the rule embodied in the prudent behavior index is likely to have an inflation rate that is both lower and more stable than the average experience. An additional question arises concerning the possible trade-off between inflation and the level of output. While this complex question will receive no definite answer from this modest study, some evidence is offered that a country that follows the rule will not only suffer no penalty in terms of output, but may in fact even enjoy a bonus in the form of a higher level of output.